Business loans mean funds other than shareholder’s equity which are acquired to fulfill long term and short term financial needs of the business. Every business or firm entails money to invest in current and fixed assets for generating revenues over a certain period of time. This money can be attained from two sources:
- Owner’s or Shareholder’s funds
- Debts/ Loans
Why loans required
Owners have limited sources of funds therefore they always need extra money to meet the financial requirements of the business. This excess money is generated through loans or debts. The person or institution which pays money is called lender and the person or institution which receives is called borrower. The borrower pays interest to lender in return for using his/her money along with principle amount.
Either loan should be preferred
This is a general perception particularly among small business entrepreneurs that investing borrowed money in business is not a wise decision because a fix amount of markup has to be paid over borrowed funds which proves burdensome to business or firm. This is fairly a wrong perception. Tangibly, return demanded by shareholders or owners over their invested funds is rather large than return demanded by the lenders. The only difference is that shareholders do not require fix return but conversely they always desire to receive and addicted to demand larger returns. In addition shareholders are not contractually bound to keep their money invested in the business. They at any time can divest their share which can be harmful for the business in particular when business or company is in dire need of funds. Lenders on the other hand are contractually bound to keep their funds invested for a certain period of time and can not withdraw funds before the expiry of mutually agreed time period. Lenders also can not demand increase in their return as the firms augment their profits earning over time. Above all interest on loan is a tax deductible expense and provides significant financial benefit to businesses or firms in the form of tax shield.
Risks associated with loans or debts
Firms using debt in capital structure called levered firms are also exposed to two types of risks. Firstly, fix amount of interest has to be paid irrespective of the fact that they earned profit or loss and secondly, lenders usually exercise first right to the assets of the firm in case of liquidation or bankruptcy. Firms can reduce above risks associated with borrowed funds considerably through efficient management of these funds. It means marginalizing the benefits from the costs coupled with borrowed funds
How much debt
Modern theories of capital structure suggest that keeping a mix of owner’s equity and lenders money is always a wise decision for strengthening the market value and Earning per Share. Here the question arises that what should be the appropriate mix? Answer to this question involves some technicalities which the financial manager of a business or company must be acquainted to understand and apply. Empirically it is observed that fifty percent share of each is a reasonable mix or more conservatively sixty percent of equity and forty percent of debt proved rational combinations in many companies.